Back in early May, I posted a note about the unusual wide swings in US stock prices that took place on Thursday, May 6. (For example, the value of the Dow-Jones Industrial Average fell by more than 1,000 points within a 15-minute interval.) There was considerable speculation that the relatively new phenomenon of high-frequency trading was somehow implicated in the odd behavior of the markets, although there was little hard evidence available. I also observed that some aspects of the incident reminded me of a market crash in 1987, when the price and trade reporting systems at times simply could not keep pace with market activity.
I have just finished reading a very interesting analysis of the events of May 6, conducted by Nanex, a firm that specializes in systems and software to distribute and process market data. Because of their business, they have a particularly good view of activity in the overall market:
Our business is supplying a real-time data feed comprising trade and quote data for all US equity, option, and futures exchanges.
The activity in these markets today is enormous, compared even to 20 years ago, because of the proliferation of electronic trading systems. Nanex claims, and I have no reason to doubt them, that the quote activity can at times exceed 1 million quotes per second. (Back around 1990, when I was involved in the development of a system to distribute digital market data, the peak rate observed was something like 500 updates per second.) Current price quotes from the various equity exchanges and electronic trading venues are aggregated, so that at any time, there is a National Best Bid and Offer [NBBO] quote: that is, the highest price [bid] anyone is willing to pay for a share of XYZ Corp, and the lowest price [ask] at which anyone is willing to sell. Trading will take place until the bid is less than the ask.
The Nanex analysis [text summary] points to two key factors that may have exacerbated the market’s volatility:
- Delays in propagating some quotes that were not visible to all market participants
- Apparent attempts to “clog” the quote reporting system by generating large numbers of spurious updates
The first problem, according to the Nanex analysis, affected primarily quotes from the New York Stock Exchange [NYSE]. It appears that quotes generated at the NYSE are put in a processing queue to be transmitted to the national system. Sometimes there is a transmission backlog, but this is not easily detected by market participants, because the quotes are only time-stamped when they are actually transmitted (that is, when they exit the queue). Thus, the apparent prices posted by the NYSE were actually older than the current state of the market [the emphasis is in the original]:
In summary, quotes from NYSE began to queue, but because they were time stamped after exiting the queue, the delay was undetectable to systems processing those quotes. On 05/06/2010 the delay was enough to cause the NYSE bid to be just slightly higher than the lowest offer price from competing exchanges, but small enough that is was difficult to detect. … This caused sell order flow to route to NYSE — thus removing any buying power that existed on other exchanges. When these sell orders arrived at NYSE, the actual bid price was lower because new lower quotes were still waiting to exit a queue for dissemination.
In other words, because of the delay in processing the NYSE quotes, the posted figures did not reflect the current (down) state of the market; and this was not evident to market participants, because of the way the quotes were time-stamped.
Nanex very sensibly recommends that the rules should require all quotes to be time-stamped when they are originated, rather than when they are transmitted (although having both time stamps would be even better). This would make processing delays visible to other market participants, and help prevent order disruptions caused by automated systems “chasing” what appears to be an attractive price, but which in fact is out of date.
The second problem identified by Nanex is more disturbing. It appears that, during the May 6 incident, there were certain market makers that generated a very high volume of quote updates for individual stocks — updates that in some cases appear rather suspicious.
During May 6, there were hundreds of times that a single stock had over 1,000 quotes from one exchange in a single second. Even more disturbing, there doesn’t seem to be any economic justification for this. In many of the cases, the bid/offer is well outside the National Best Bid/Offer (NBBO)
The fact that in some cases the prices quoted were not close to the current NBBO is suspicious; there is really no reason to post or update a quote that has essentially no chance of generating a trade. As Nanex observes, these might have been caused by a programming error, or by malicious software; but they might also represent a deliberate attempt to “clog” the quote reporting system. Their hypothesis is that it may be an attempt to gain a transient advantage for a high-frequency trading system. In a business where microseconds matter, someone might generate a large number of quote updates that his competitors would have to process (thus consuming time), but which he, having generated them, could ignore. Although I think it would be exceedingly hard to prove that something like this was going on, it would not surprise me in the least. Having worked in the investment banking world for many years, I think it is generally a safe assumption that, if it is possible to “game” a trading system, someone will try it.
Nanex proposes another rule change to address this: a specified interval (they suggest 50 milliseconds) must elapse before a quote can be updated, unless the quote is “hit” (that is, has a trade executed against it). As they point out, 50 ms is approximately the minimum round-trip time for messages to travel from New York to California, or vice versa, so it is hard to see how this could legitimately handicap anyone.
All of this is fascinating stuff, and I urge you to have a look at the Nanex report if you are interested in securities markets. It may be another piece of evidence that we are able to increase the complexity of our systems faster than we can increase our ability to understand and control them.
Update Tuesday, 29 June, 6:55 EDT
I forgot to mention that the SEC and CFTC have issued a preliminary report [PDF, 151 pp], dated May 18, 2010, on their analysis of the May 6 incident.
I also want to thank Nanex for their work in doing the analysis that I discussed above, and for making it available. Although they obviously have an interest in having the markets work well, it is a pleasure to see that they are being responsible participants.
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